What $50 means for oil stocks

Sep 7, 04

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Bongaigaon Refinery86.0067.2027.98 Chennai Petro200.65159.6525.68 Essar Oil22.1018.8916.99 Reliance Ind558.45484.7515.20 ONGC805.45711.3513.23 Kochi Refineries190.90173.709.90 Indian Oil Corp437.60405.607.89 Gail199.30184.807.84 HPCL324.20310.854.29 BPCL350.25340.003.01 MRPL46.9045.552.96  Clearly, the performance of companies operating in different segments in the oil chain is becoming stark with the government trying to marry multiple - and often contradictory - objectives which include containing oil price inflation, retaining subsidies on kerosene and LPG, at the same time trying to optimise revenues from the oil industry.  The net result is that a part of the burden of subsidising some petroleum products for the domestic sector falls unevenly on oil companies, affecting their profits.  Essentially, there are four legs to the Indian oil story. The first is the change in crude oil prices, which is a function of global demand-supply forces.  The second leg is refining margins which are, again, a function of demand for petro-products and refining capacities.  The third is the marketing margin, which is the difference between the cost of producing petro-products and the sale price to the end-customer.  The fourth is the subsidy on kerosene and LPG which is shared by the oil firms and the government. Intertwined in these is also the levies, including the import tariffs and excise duty on crude as well petro-products, which impacts the profitability of oil companies.  Fortunately, regional refining margins have been very strong. Product prices across Asia have been firm on account of robust demand from China apart from some supply constraints. In the second week of September, Singapore complex refining margins touched an all-time high of $10.22 per barrel (based on Dubai oil prices).  Though analysts see this as temporary, tight demand-supply conditions should ensure strong margins for a quarter or two. According to Merrill Lynch, any slowdown in consumption could be another 12-18 months away.  "Asian gross refining margins (GRMs) should ease to around $6-7 per barrel over the next two quarters which itself is fairly strong," says Susanta Mazumdar, head of research, UBS Warburg.  For the Indian refining majors, analysts expect refining margins to be in the range of $4-5 per barrel for fiscal 2005, but a difference of $1 could swing profits 25 per cent either way.  On slippery ground?
Even though the earnings of R&M firms are highly sensitive to refining margins, these companies could see their profits plunge because of the higher subsidy losses on account of LPG and kerosene and weaker marketing margins on petrol and diesel.  Subsidy losses for downstream companies will be considerably higher this year compared to FY04. Year to date, crude prices have risen nearly 65 per cent, but prices of petrol and diesel at the pump have been raised by only 11 per cent and 9 per cent respectively.  The government, however, altered the excise and customs duty structure to share the burden. Since June 2004, it has cut excise duty on auto fuels twice - duties on petrol, diesel, kerosene and LPG have been lowered by 700 bps, 600 bps, 800 bps and 400 bps respectively.  In August, it also reduced the import duty by 500 bps on the four retail consumption products while keeping tariffs on crude unchanged, thus, reducing the effective protection for refiners from 6.5 per cent to 3.8 per cent.  While these measures impact refining margins adversely by around 20 per cent, marketing margins of R&M firms are likely to be around 30 per cent lower than FY04 levels despite the excise duty cuts. If regional refining margins remain steady, however, pure refininers may see earnings growth.  For R&M firms, the burgeoning subsidy on account of LPG and kerosene is also a bane. Based on year-to-date prices, the LPG/kerosene subsidy bill is likely to be 16,600 crore, of which, the government will have to cough up Rs 2,500 crore, upstream companies Rs 4,800 crore and three R&M firms Rs 9,300 crore.  In FY04, R&M firms incurred a subsidy loss of Rs 4,300 crore. 
 

Partners in subsidy losses
FY2004 (Rs billion)	BPCL	HPCL	IOC	Total
Subsidy on LPG/kerosene	27	28	65	120
Payment from government	11	11	25	47
Payment from upstream	5	7	19	30
Subsidy losses	12	10	21	43
FY2005E
Subsidy on LPG/kerosene	37	38	91	166
Payment from government	6	6	13	25
Payment from upstream	5	11	32	48
Subsidy losses	26	21	46	93
Based on year-to-date prices Source: Kotak Securities

 Higher crude oil prices will only increase under-recoveries, if the prices of kerosene/LPG are not raised. Assuming crude prices at $42 and international price of LPG at $464 per tonne, under-recoveries could be marginally over Rs 20,000 crore.  Accordingly, the share of oil companies' losses will also go up. One positive is that these firms will see tangible inventory gains due to the run-up in crude prices.  Last quarter, HPCL and BPCL recorded inventory gains to the tune of Rs 170 crore each and IOC saw gains of Rs 300 crore. This quarter, too, there could be similar gains. Overall, analysts expect consolidated earning of all three R&M companies - IOC, HP and BP - to fall in fiscal 2005.  Among the three, IOC is better off because it derives the least contribution from marketing which is under more serious threat. IOC's earnings are expected to fall by 7 per cent this fiscal, while that of BP and HP are likely to fall by 27 and 28 per cent respectively.
 

Earnings estimates for FY05
(In Rs)	FY04	FY05	CMP (Oct 7)	Trailing P/E (x)	Forward P/E (x)
Bharat Petroleum	63.80	46.39	350.25	5.49	7.55
Hindustan Petroleum	55.07	39.45	324.2	5.89	8.22
Indian Oil	65.00	60.00	437.60	6.73	7.29
Oil & Natural Gas	65.84	83.06	805.45	12.23	9.70
Gas Authority	22.10	22.30	199.30	9.00	8.99
Kochi Refineries	32.00	46.50	190.90	5.97	4.11
Chennai Petroleum	26.90	35.65	200.65	7.46	5.63
Reliance Industries	37.00	48.00	558.45	15.09	11.63
Source: Based on consensus estimates by Motilal Oswal, Morgan Stanley, I-Sec, Kotak Securities and Enam. Not all broking houses have estimates for all companies.

 While R&M companies will be clear losers in a rising crude price environment, upstream companies like ONGC and Gail may emerge winners. However, upstream companies' profits growth, too, will be moderate since they have to foot a third of the subsidy bill.  In the first quarter of fiscal 2005, ONGC, Gail and OIL contributed Rs 1,190 crore towards the subsidy burden of R&M in the ratio 68 per cent, 19 per cent and 13 per cent respectively.  Based on the prevailing prices, ONGC's subsidy burden could be higher by over 50 per cent. Yet, rising crude prices will by and large be favourable for ONGC.  The arithmetic is simple: the amount of crude sold by ONGC roughly equals the total consumption of LPG and kerosene in India, so, ONGC will always stand to benefit in a rising crude price environment, assuming that it will bear only a portion (albeit a substantial portion) of the apportioned one-third losses for upstream firms.  However, analysts argue that Gail may end up a loser. In Q1FY05, Gail's subsidy losses were Rs 226 crore, 30 per cent of pre-subsidy pre-tax profits. Gail is not thus not making any profit from its LPG production, if subsidy losses are included.  Not all analysts, however, are bullish on ONGC. "We have raised our earnings forecast to factor in rising international prices. However, deteriorating fundamentals remain a cause for concern - ONGC